Optimism's not what it used to be

This is the time of year when commentators and analysts tend to make rash forecasts which are either overtaken by events or thrown into reverse by them. In recent years it has been shown that most forecasters of stock market developments not only fail to correctly predict share price movements over 12 months but typically fail to get even near the direction of the market.

Too much precision is expected of economists and financial analysts, which makes them vulnerable to ridicule when they prove to be way off beam.

An obvious divide is between the 'optimists' and the 'pessimists'. Over the holidays, however, I was introduced to what, for me, was a new refinement, that of 'paranoid optimism'. In his fascinating book 20:21 Vision - The Lessons of the 20th Century for the 21st, Bill Emmott, the editor of the Economist, says he derives this term from a winemaker who told him that 'paranoid optimism' was the phrase used in the vineyards to describe the balance between 'positive expectations and a keen awareness of risk'.

According to this theory, progress suggests that each vintage should be better than the last, which gives the winemaker confidence, but that confidence is tempered by fear of what Harold Macmillan termed 'events, dear boy, events' - in this case, too much sun, rain at the wrong time, a vine disease perhaps.

Emmott says the winemaker's 'paranoia helps him to make preparations to try to limit or at least cope with the dangers. Yet it does not alter his basic optimism'.

The sweep of Emmott's book is rather broader than events in this year's stock or foreign exchange markets. Given the importance of the way politics and economics interact - think of Weimar inflation, the 1929 crash, world depression, protectionism, the rise of Hitler in the 1920s and 1930s - Emmott seeks to answer two key questions. Will the US continue to 'lead the world and keep the peace'? Will capitalism's strengths outweigh its weaknesses sufficiently to keep the show on the road?

Emmott himself emerges as a 'paranoid optimist'. Whereas from an early stage of the 20th century the British empire was showing cracks, the US 'hegemony' is not seriously threatened, he says - not least because of the $400bn a year the nation spends on defence, which dwarfs even the wildest estimates of what China might do in the foreseeable future.

Talking of China, the fashionable forecasters are all obsessed by this country now, just as they were obsessed by Japan in the 1970s and 1980s. I seem to recall that at the British Treasury in the 1970s almost any visitor who had just returned from Japan was dubbed a 'Nippon Bore'. There is now no shortage of China Bores, even though, as a Japanese official gleefully pointed out not long ago, 'per capita income in China is about a seventieth of that in Japan'.

This is not to deny the vast potential in China, or the speed at which that economy is growing. (Although the speed, at present, is so terrifying that the Chinese economy appears to be running out of power stations - a case, perhaps, of a developing economy literally overheating.)

But let us return to Western capitalism. The weaknesses that give scope to its critics have certainly been in the ascendancy of late, with the crisis at the Italian dairy group Parmalat, and the Bush administration's links with Halliburton and contracts in Iraq, giving us a timely reminder of just how badly capitalism can behave.

Socialism and communism were reactions against the inequality and exploitation of capitalism, as well as against the disruptive 19th century business cycles that seemed to produce so much waste. As long as the communist threat was there, capitalism had an incentive to improve its behaviour. Since the end of the Cold War the nearest thing to the communist threat has been the anti-globalisation movement.

The former Treasury economic adviser Robert Neild once declared: 'The word globalisation is a substitute for thought'. The world is global by definition. But if anything the common thread among 'anti-globalisation' protesters is concern about unbridled capitalism - or, more accurately, capitalism that is not bridled enough, despite all the 'regulation, supervision and harmonisation'.

In evidence to the Lords' select committee on economic affairs, under Lord Peston, Nicholas Stern (then World Bank chief economist and now at the UK Treasury) pointed out that a better term for 'globalisation' was 'integration'.

There have been three waves of 'globalisation' or 'integration': 1870 to 1914; 1950 to 1980 (principally, closer integration of the industrialised countries in the Organisation for Economic Cooperation and Development); and 1980 up to today.

As Professor Stern pointed out, in the latest integration wave, manufactured goods rose from a quarter of developing countries' exports to three-quarters.

The fashionable focus these days is on the export-led growth of China and India. Experts calculate that at least half of the Chinese exports are accounted for by foreign-owned multinationals, predominantly American.

Many of these 'Chinese' exports go to the US itself, the attraction being the combination of low-cost production and an undervalued Chinese exchange rate - a kind of double whammy for some US domestic producers, and a source of the recent rise in American protectionist tendencies.

The US Treasury has been hoping for some time that China and other Asian countries that tie their currencies to the dollar, will revalue their currencies or allow them to float upwards, to ease trade tensions. In the attempt to win the next election the Bush administration has not only been working on 'the best economic recovery money can buy' while the Federal Reserve has been keeping interest rates close to rock bottom; it has also been encouraging the dollar to drop so as to arrest the decline of the US balance of payments.

The OECD estimates that last year US exports of goods and services amounted to $1,000bn, but imports were $1,500bn. US gross domestic product, again in round figures, is $10,000bn.

I find these figures little short of sensational. At a time when even the $400bn plus of US military spending is finding the States' might stretched in Iraq, the underlying US economic position is uneasily reminiscent of all the problems Britain suffered when sentiment turned (in the 1950s and 1960s) against the 'sterling area' arrangements under which we ran deficits papered over by empire holdings of funds in London.

One way in which the US has been living profligately is in its insatiable demand for oil, the attempt to secure supplies of which is a big factor behind its presence in Iraq.

Meanwhile most of the strain of the policy of unabashed devaluation of the dollar is being taken up by the euro and pound. As recently as 18 months ago Paul Krugman was telling the Peston Committee: 'You would not expect it [the euro - then 83 cents] to go all the way back to $1.17' (at which it was introduced in 1999).

Last week, the euro rose above $1.25 and the pound seemed to be heading for $1.80. The asymmetric impact of the dollar devaluation on the euro and the pound is bad news for UK and Eurozone exporters at a delicate time.

The general US economic scenario looks fraught with medium-term problems. At some stage we shall need a mini-Bretton Woods conference to restore some sanity to international economic policy, but that will only happen when the US panics.

I am not sure whether I end up being a paranoid optimist or a normal pessimist. But I do know that one of the best wines I was hoping to drink over Christmas turned out to be corked.